BACHELOR IN BUSINESS ADMINISTRATION (BBA YEAR 3)

Transcription

1 BACHELOR IN BUSINESS ADMINISTRATION (BBA YEAR 3) MODULE 2 BUSINESS ADMINISTRATION 3A STUDY GUIDE Copyright 2013 MANAGEMENT COLLEGE OF SOUTHERN AFRICA All rights reserved; no part of this book may be reproduced in any form or by any means, including photocopying machines, without the written permission of the publisher REF: BA2013

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3 MODULE CONTENTS FINANCIAL MANAGEMENT TOPIC NUMBER TOPIC PAGE(S) Preface 2 Reading 3 1 Financial Management: Important concepts 5 2 Financial projection 17 3 Management of working capital 37 4 Capital expenditure decisions 69 5 Financing decisions: Sources and costs 91 6 Financial Analysis Budgets 129 Bibliography 156 MANCOSA BBA Year 3 1

4 PREFACE The aim of this module on Financial Management is to introduce you to the concepts of financial management and to understand the role of the financial manager in a business environment. Throughout the module think points and illustrative examples have been included. Self-assessment activities and solutions appear at the end of each topic in order to test your understanding of the section. You are strongly advised to do the self-assessment activities after studying each topic as it will stimulate your interest and enhance your understanding of the work covered in the section. In order to ensure a quality module, a number of reference books have been consulted to draw up this module. Since no single textbook covers all the topics of this module adequately, no textbook is prescribed. In order to enhance your knowledge, you are advised to consult the recommended books that are indicated at the start of each topic. MANCOSA BBA Year 3 2

5 READING Prescribed There is no prescribed book for this module. This study guide will serve as your prescribed reading. Additional reading The following books are recommended for further reading. The books that are recommended for each topic are indicated at the start of the topic. Correia, C., Langfield-Smith, K., Thorne, H. and Wilton, R.W. (2008) Management Accounting: Information for managing and creating value. 1 st Edition. Berkshire: McGraw-Hill Education. Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6 th Edition. Cape Town: Oxford University Press. Dempsey, A. and Pieters. (2005) H.N.Introduction to Financial Accounting 5 th Edition. Durban: LexisNexis. Hampton, J.J. (2003) Financial Decision Making: Concepts, Problems and Cases. 4 th Edition. New Delhi: Prentice-Hall. Helfert, E.A. (2003) Techniques of Financial Analysis. 11 th Edition. New York: McGraw-Hill/Irwin. Higgins, R.C. (2007) Analysis for Financial Management. 8 th Edition. New York: McGraw-Hill/Irwin. Keown, A., Martin, J.D., Petty, J.W. and David, F.J. (2002) Financial Management: Principles and Applications. 9 th Edition. New Delhi: Prentice-Hall. Marshall, D.H., Mcmanus W.W. and Viele D.F. (2007) Accounting: What the numbers mean. 7 th Edition. New York: McGraw-Hill. McLaney, E. (2003) Business Finance: Theory and Practice. 6 th Edition. Essex: Prentice Hall. Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1 st Edition. North Ryde: McDraw-Hill. Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5 th Edition. Durban: LexisNexis Butterworths. Van Horne, J.C. and Wachowicz Jr., J.M. (2003) Fundamentals of Financial Management. 11 th Edition. New Delhi: Prentice-Hall. MANCOSA BBA Year 3 3

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7 TOPIC 1 FINANCIAL MANAGEMENT: IMPORTANT CONCEPTS LEARNING OUTCOMES Students should be able to: explain the responsibilities of the financial function and financial management. discuss the goals of financial management in the pursuit of maximising wealth. familiarise themselves with the important concepts used in financial management. distinguish between fixed capital and working capital. CONTENTS 1. Introduction 2. Financial function 3. Financial management 4. Goals of financial management 5. Important concepts in financial management 6. Self-assessment activities 7. Solutions MANCOSA BBA Year 3 5

8 READING Recommended reading Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6 th Edition. Cape Town: Oxford University Press. pp Hampton, J.J. (2003) Financial Decision Making: Concepts, Problems and Cases. 4 th Edition. New Delhi: Prentice-Hall. pp Van Horne, J.C. and Wachowicz Jr., J.M. (2003) Fundamentals of Financial Management. 11 th Edition. New Delhi: Prentice-Hall. pp.2-7 MANCOSA BBA Year 3 6

9 1. INTRODUCTION According to Hampton (2003: 1) the role of the financial manager has changed considerably over the years. Traditionally, their roles involved accurate record keeping, preparation of financial statements, and managing cash. Nowadays financial managers are involved with the amount of capital employed by the firm, the allocation of funds to various projects and activities, and the measurement of the results of each allocation. Financial managers need to acquire skills to make correct decisions in a fast-moving and technologically changing environment. THINK POINT 1! A student asks: I have no intention of becoming a financial manager, so why do I need to understand financial management? Respond to this question. 2. FINANCIAL FUNCTION Cronje et al. (2004:393) state that a business must acquire assets such as property, machinery, vehicles, equipment, raw materials and trade inventories in order to function efficiently. Resources such as management and labour, services such as electricity, and communication facilities are also required. In order to obtain the required assets, resources and services, a business requires funds (capital). Suppliers of these funds expected to be satisfactorily rewarded for making their funds available to the business as soon as income is generated through sales. Funds therefore flow continually to and from the business. Cronje et al. (2004:394) add that it is with this flow of funds that the financial function is concerned with. In particular the financial function is concerned with: the acquisition of funds (called financing), the application of funds to acquire assets (called investment), and the administration of, and reporting on, financial matters. MANCOSA BBA Year 3 7

10 3. FINANCIAL MANAGEMENT Financial management, according to Cronje et al. (2004:394), is responsible for the efficient management of all facets of the financial function. It must contribute to the achievement of the main objective of the enterprise (i.e. maximisation of shareholder wealth) through the performance of the following tasks: Efficient financial analysis, reporting, planning, and control Managing the acquisition of funds Managing the application of funds Horne and Wachowicz (2003:7) illustrates how financial management fits into the operations of a typical manufacturing firm: Figure 1-1 BOARD OF DIRECTORS PRESIDENT (Chief Executive Officer) VICE PRESIDENT Operations VICE PRESIDENT Finance VICE PRESIDENT Marketing TREASURER *Capital budgeting *Cash management *Commercial banking *Credit management *Financial analysis *Financial planning *Investor relations *Risk management *Tax planning CONTROLLER *Cost accounting *Cost management *Data processing *General ledger *Government reporting *Internal control *Financial statements *Prepare budgets *Prepare forecasts The Vice President of finance (or Chief Financial Officer) usually reports to the MANCOSA BBA Year 3 8

11 President or Chief Executive Officer. The controller s responsibilities are largely accounting in nature. The responsibilities of the treasurer falls into decision areas usually associated with financial management. 4. GOALS OF FINANCIAL MANAGEMENT The specific goals of financial management in pursuit of maximising wealth, according to Hampton (2003:9), may be summarised as follows: Maximise profit: Finance should aim towards a high level of primary long-term and secondarily short-term profits for the enterprise. Minimise risk: Finance should always pursue courses of action that avoid unnecessary risks and try to anticipate problem areas. Maintain control: There must be constant monitoring of funds that flow in and out of the enterprise to ensure that they are safeguarded and properly utilised. Achieve flexibility: Learning to deal with an uncertain future is important. It is through careful management of funds and activities that flexibility is gained. If the enterprise has identified adequate sources of funds in advance of needs, it will be flexible when cash is required. Liquidity: The enterprise must have sufficient cash at all times to meet its obligations. 5. IMPORTANT CONCEPTS IN FINANCIAL MANAGEMENT Important concepts in financial management include the following: Capital Money market and capital market Financial statements Financial structure Investment Financing Liquidity Solvency Profitability 5.1 Capital Capital may be defined as the funds invested in an enterprise. Capital may also include funds that have been earned by the enterprise but not distributed to the owners (i.e. retained profits). When determining the capital requirements for an enterprise one needs to estimate the fixed capital requirements as well as working MANCOSA BBA Year 3 9

12 capital requirements. Fixed capital refers to capital that is required for acquisition of non-current assets such as land, buildings, machinery, equipment, and vehicles. Assets are resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. Non-current assets are assets that have a useful life of more than one year. Working capital is capital required to obtain current assets. Current assets are assets that are expected to be turned into cash within a year e.g. inventories/materials, credit allowed to debtors. Capital may be classified as follows: Short-term capital: is capital usually available for a period of up to a year. Medium-term capital: is capital available for a period between one and five years. Long-term capital: is capital that is made available for a period of five years or more. Capital may be obtained from the following sources: Own capital: is capital provided by the owner(s) of the enterprise. Borrowed capital: is capital that is obtained from banks and other financial institutions on which interest is payable. 5.2 Money market and capital market When enterprise needs to borrow funds, it can approach institutions in the money market or capital market. The money market consists of institutions and individuals who lend or borrow money in the short-term i.e. for a period of one day or for months e.g. a bank overdraft facility. The period of transactions depends on the needs of users and institutions with a shortage of funds. The capital market consists of institutions and individuals who lend or borrow money in the long-term e.g. a mortgage bond repayable over a period of 20 years. MANCOSA BBA Year 3 10

13 5.3 Financial statements Financial statements report on the financial position of an organisation at a certain point in time and the changes in the financial position over a period of time. The financial statements and what they are intended to report on are illustrated below: FINANCIAL STATEMENT Balance sheet Income statement Statement of changes in equity Statement of cash flows REPORTS ON: Financial position on a certain date. Profit for a particular period. Investments by and distributions to owners. Cash flows during the period. 5.4 Financial structure The financial structure of an enterprise is graphically illustrated in the form of a balance sheet. The balance sheet reports on the financial position of an organisation at a specified point in time. It is basically a summary of an organisation s assets, equity and liabilities at a point in time. This is illustrated below: Figure 1-2 ASSETS Non-current assets Current assets EQUITY AND LIABILITIES Equity Liabilities Non-current liabilities Current liabilities Asset structure: Investment/ Application of funds Capital structure: Financing/ Suppliers of funds The following are brief explanations of the main items in the balance sheet: Assets are the resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. (Refer to paragraph 5.1 for a distinction between current assets and non-current assets.) Liabilities are claims on the assets of an organisation. Simply put, it refers to what an organisation owes. Non-current liabilities are debts that are payable after more than MANCOSA BBA Year 3 11

14 one year from the balance sheet date. Current liabilities are debts that are payable with 12 months of the balance sheet date. Equity or Owner s equity may be viewed as the residual claim that the owner(s) has on the assets of the organisation after all the liabilities have been settled. It normally consists of two parts viz. that which is invested in the organisation and that which is earned by the organisation and left in the organisation (i.e. retained profits). 5.5 Investment Investment may be described as the use of capital to acquire non-current assets such as property and machinery to be put to productive use as well the acquisition of current assets such as inventories in order to generate income. 5.6 Financing This refers to various ways by which an enterprise obtains its funds in order to meet its capital needs. Financing may be secured from owners, suppliers, and creditors while other funds may arise from the retained earnings in the enterprise. 5.7 Liquidity Liquidity is the measure of the ability of an enterprise to have sufficient cash on hand to meet its obligations at all times. In other words, the enterprise can pay all its bills when due. 5.8 Solvency Solvency refers to the ability of an enterprise to be able to repay its debts and satisfy any claims against it. The total debt (liabilities) must be covered by a realistic value of the total assets. An enterprise is considered to be insolvent if the total liabilities exceed the realistic value of assets. 5.9 Profitability Profitability is the effectiveness with which an enterprise has employed both the total assets and the net assets (equity). This is assessed by relating net profit to resources utilised in generating the profit. Measures to assess profitability are discussed in topic 6. MANCOSA BBA Year 3 12

15 6. SELF-ASSESSMENT ACTIVITIES 6.1 Match the terms in column A with the statements in column B. Write down the Column A 1. Assets letter of the correct answer. 2. Non-current assets 3. Current assets 4. Equity 5. Liabilities 6. Non-current liabilities 7. Current liabilities 8. Investment 9. Financing 10. Liquidity 11. Solvency 12. Profitability A B C D E F G H Column B The residual claim that the owner(s) has on the assets of the organisation after all the liabilities have been settled. Debts that are payable within 1 year of the balance sheet date. The resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. The claims on the assets of an organisation. The various ways by which an enterprise obtains its funds in order to meet its capital needs. The use of capital to acquire non-current assets to be put to productive use as well the acquisition of current assets. The measure of the ability of an enterprise to have sufficient cash on hand to meet its obligations at all times. The ability of an enterprise to be able to repay its debts and satisfy any claims against it. I J K L Assets that have a useful life of more than one year. Debts that are payable after more than one year from the balance sheet date. The effectiveness with which an enterprise has employed both the total assets and the net assets (equity). Assets that are expected to be turned into cash within a year. 6.2 What is the main responsibility of financial management? 6.3 Explain the following goals of financial management: Maximise profit Minimise risk Maintain control Achieve flexibility Liquidity MANCOSA BBA Year 3 13

16 6.4 Briefly state the function of each of the following financial statements. Balance sheet Income statement Statement of changes in equity Statement of cash flows 6.5 Study the following information and answer the questions that follow. Pixma Limited began operations in January with R obtained from selling ordinary shares at a par value of R2 each. During the year it purchased plant and equipment for R and land for R , financing the purchase with a mortgage bond of R , a long-term loan of R , and cash for the balance. On 31 December 20.08: The amount owing by trade debtors totaled R R was owing to trade creditors. Inventories on hand amounted to R The bank balance was overdrawn by R Retained earnings at the end of the financial year amounted to R Calculate the following on 31 December 20.08: Own capital Borrowed capital Current assets Non-current assets Total assets Equity Non-current liabilities Current liabilities Total liabilities MANCOSA BBA Year 3 14

17 7. SOLUTIONS THINK POINT 1! One needs to prepare oneself for the workplace of the future. In order to reduce costs, many businesses are reducing management jobs and squeezing together the various layers of the corporate pyramid. Consequently, the responsibilities of the remaining managers are being broadened. A successful manager must be able to move both vertically and horizontally within an organisation. Therefore, mastery of basic financial management skills is important requisite in the workplace C 2. I 3. L 4. A 5. D 6. J 7. B 8. F 9. E 10. G 11. H 12. K 6.2 Financial management is responsible for the efficient management of all facets of the financial function. It must contribute to the achievement of the main objective of the enterprise (i.e. maximisation of shareholder wealth). 6.3 Refer to paragraph Refer to paragraph 5.3. MANCOSA BBA Year 3 15

18 6.5 Amount (R) Workings Own capital R R Borrowed capital R R Current assets R R Non-current assets R R Total assets R R Equity R R Non-current liabilities R R Current liabilities R R Total liabilities R R MANCOSA BBA Year 3 16

19 TOPIC 2 FINANCIAL PROJECTION LEARNING OUTCOMES Students should be able to: explain the purpose of pro forma statements. prepare pro forma income statements and balance sheet. explain the significance of cash budgets. CONTENTS 1. Introduction 2. Pro forma financial statements 3. Cash budgets 4. Self-assessment activities 5. Solutions MANCOSA BBA Year 3 17

20 READING Recommended reading Helfert, E.A. (2003) Techniques of Financial Analysis. 11 th Edition. New York: McGraw-Hill/Irwin. pp Higgins, R.C. (2007) Analysis for Financial Management. 8 th Edition. New York: McGraw-Hill/Irwin. pp MANCOSA BBA Year 3 18

21 1. INTRODUCTION According to Helfert (2003:171) business plans are usually structured around specific goals and objectives. The plans usually outline strategies and actions for achieving desired short-term, medium-term and long-term results. Eventually these plans are quantified in financial terms, in the form of pro forma statements (projected financial statements). Greater insight into the funding implications of projected activities may be gained through the use of detailed cash budgets and cash flow statements. The main techniques of financial projection may fall into two categories: Pro forma financial statements Cash budgets 2. PRO FORMA STATEMENTS According to Higgins (2007:87) pro forma statements are the most widely used means for financial projection (forecasting). Pro forma statements can be simply described as a prediction of what the company s financial statements will look like at the end of the forecast period. They include an income statement and a related balance sheet. A third key statement, the cash flow statement, may be prepared to display the expected movement of funds during the forecast period. One of the main purposes of pro forma statements is to estimate a company s future need for external funding, which is an important first step in financial planning. The process can simply be described as follows: If the forecast indicates that the enterprise s assets will increase to R , but liabilities and owners equity will only amount to R , then one can assume that R in external funding is required. THINK POINT 1! What deduction would you make if the pro forma statements of an enterprise indicate that assets will fall below projected liabilities and owners equity? Put in the form of an equation, one could say that: External funding required = Total assets (Liabilities + Owners equity) MANCOSA BBA Year 3 19

22 2.1 Pro Forma Income statement This statement represents a broad operational outlook for the enterprise. It projects the amount of profit the enterprise expects to earn for the forecast period. The pro forma income statement is prepared first because the amount of after-tax profit developed here must later be reflected in the pro forma balance sheet. The following four steps may be followed in developing a pro forma income statement: Sales projection Determine production (or purchases) schedule, cost of sales and gross profit Estimate other expenses Calculate expected profit by completing the pro forma income statement These steps will be explained using the example of Dunbar Manufacturers. Step 1: Sales projection The starting point for the income statement is a forecast of the unit and Rand value of sales. This may be estimated in a number of ways ranging from trend-line projections to detailed departmental forecasts by individual product. Assume that Dunbar Manufacturers estimates that its sales for the first six months of 20.9 to be R This comprises the sale of units at a price of R200 per unit. This may be illustrated in Figure 2-1 as follows: Figure 2-1 Sales projection for 6 months R200 each = R Step 2: Determine production (or purchases) schedule, cost of sales and gross profit Based on the sales projection, the production plan (or purchases plan in the case of a merchandising enterprise) may now be determined. The number of units to be produced will depend upon of following three factors: Opening inventory Sales forecast Closing inventory MANCOSA BBA Year 3 20

23 Suppose that Dunbar Manufacturers expects an opening inventory of 150 units at R120 each and that its desired closing inventory is 200 units. The number of units that should be produced for the forecast period (6 months) is calculated in Figure 2-2: Figure 2-2 Production requirements for 6 months Sales forecast (See Figure 2-1) Desired closing inventory Total budgeted production/purchasing needs Opening inventory Required production/purchases units 200 units units (150) units units We now examine the cost of producing these units. Assume that Dunbar Manufacturers expect a 10% increase in all production costs. If the unit production cost of R120 (as indicated in the cost of opening inventory) comprises direct materials R60, direct labour R40 and factory overheads R20, then a 10% increase will result in the unit cost increasing by R12 as seen in Figure 2-3 below: Figure 2-3 Unit cost R Direct materials 66 Direct labour 44 Factory overheads 22 Total unit cost 132 The total cost of producing the required number of units may be calculated as follows: Figure 2-4 Total production cost for 6 months R132 each = R MANCOSA BBA Year 3 21

24 Now that the sales projection and production costs are available, the costs of sales can be determined. The value of cost of sales depends upon the inventory valuation method used. Suppose that Dunbar Manufacturers uses the FIFO (first-in-first-out) method. Using this method, the cost of sales will be calculated firstly from the sale of the opening inventory and then from the sale of the goods to be manufactured during the forecast period. The calculation is illustrated in Figure 2-5 below: Figure 2-5 Cost of sales for 6 months R Opening inventory 150 R Production less closing inventory = 850 R Expected cost of sales Using the FIFO method, Dunbar Manufacturers expected sales of units would first come from the 150 units (at R120) in opening inventory. The remaining 850 units would come from the production of units. This would result in the desired closing inventory of 200 units. The value of the closing inventory is required for the balance sheet and may be calculated as follows: Figure 2-6 Value of closing inventory R Opening inventory (Figure 2-5) Total production cost (Figure 2-4) Total inventory available for sale Cost of sales (Figure 2-5) ( ) Closing inventory OR 200 R132 = R MANCOSA BBA Year 3 22

25 Step 3: Estimate other expenses The figures from the previous period are often used as a base for expense projections. Estimates are required for selling, general, administrative and other operating expenses. Interest expense is then charged according to the provisions of the enterprise s outstanding debt. The income statement will be complete once the income tax (not applicable to sole proprietorships and partnerships) is estimated to determine the profit after tax. In the case of Dunbar Manufacturers the following estimates apply: General and administrative expenses R Interest expense R2 400 Income tax 25% Step 4: Calculate expected profit by completing the pro forma income statement Using estimates and other information from steps 1 to 3, the pro forma income statement of Dunbar Manufacturers can now be drawn up: Figure 2-7 Pro Forma Income Statement R Sales Cost of sales ( ) Gross profit General and administrative expenses (13 000) Income from operations Interest expense (2 400) Profit before tax Income tax (13 600) Net profit Preparing pro forma income statement and pro forma balance sheet using the percentage-of-sales method According to Higgins (2007:88) a straight forward yet effective way to forecast is to MANCOSA BBA Year 3 23

26 tie many of the income statement and balance sheet figures to future sales. The rationale for this approach is the tendency for variable costs and most current assets and current liabilities to vary directly with sales. Obviously, this will not hold true for all items in the financial statements, and certainly some independent estimates of individual items will be required. Percentage-of-sales forecast may be done using the following three steps: Step 1 Examine historical data to determine which financial statement items varied in proportion to sales in the past. This enables the forecaster to determine which items can be safely estimated as a percentage of sales and which must be forecast using other information. Step 2 A forecast of sales must now be done. Since many items are linked to the sales forecast, it is important to estimate sales as accurately as possible. Step 3 The last step is to extrapolate the historical patterns to the newly estimated sales e.g. if inventories have historically been about 15% of sales and next year s sales are forecast to be R , then one would expect inventories to be R Figure 2-8 Consider the income statement of Dino Ltd for 20.8: Income Statement for 20.8 R Sales Cost of sales ( ) Gross profit Operating expenses (36 000) Income from operations Interest expense (4 000) Profit before tax Income tax (25%) (10 000) Net profit MANCOSA BBA Year 3 24

27 If Dino Ltd identified cost of sales, operating expenses and interest expense as varying in proportion to sales in the past, then the following percentages would be obtained: Figure 2-9 Expenses expressed as a percentage of sales Cost of sales = R = % Sales R Operating expenses = R = 15% Sales R Interest expense = R4 000 = 1.667% Sales R If the sales forecast of Dino Ltd for 20.9 is R , then the pro forma income statement for 20.9 will appear as follows: Figure 2-10 Pro Forma Income Statement for 20.9 R Sales Cost of sales (66.667% of R ) ( ) Gross profit Operating expenses (15% of R ) (45 000) `Income from operations Interest expense (1.667% of R ) (5 000) Profit before tax Income tax (25% of profit before tax) (12 500) Net profit MANCOSA BBA Year 3 25

28 Consider the balance sheet of Dino Ltd for 20.8: Figure 2-11 Balance sheet for 20.8 ASSETS Non-current assets R Percentage of sales of R Equipment % Current assets % Inventories % Accounts receivable % Cash and cash equivalents % Total assets % EQUITY AND LIABILITIES Equity % Non-current liabilities - 0 Current liabilities Accounts payable % Total equity and liabilities % From the above one observes that the equipment represents % of sales, inventories of R is % o sales and so on. Total assets represent % of sales. Let us assume that the sales of Dino Ltd is expected to increase from R to R for We further assume that the after tax return on sales is 20% and 50% of profits is paid out in dividends. Based on these figures, expected profit is R (20% of R ) of which R will be paid out as dividends. The pro forma balance sheet for 20.9 is expected to be as follows: MANCOSA BBA Year 3 26

29 Figure 2-12 Pro Forma Balance Sheet for 20.9 R ASSETS Non-current assets Equipment Current assets Inventories Accounts receivable Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity ( Retained profit) Non-current liabilities External funding required? Current liabilities Accounts payable Total equity and liabilities? The percentages obtained from figure 2-11 were used to calculate the amounts for 20.9 with the exception of equity. For example, the equipment figure of R is % of the expected sales of R for Equity increases by the portion of the net profit that is not expected to be given as dividends i.e. the portion retained by the company. Total equity and liabilities add up to R which is R less than the total assets of R The R represents the external funding required. This may be represented as follows: MANCOSA BBA Year 3 27

30 External funding required = = = = Total assets (Liabilities + Equity) R ( ) R R R Another way of looking at the external funding required is as follows: If sales increases by R (from R to R ) then 20% will be financed by accounts payable, necessitating R (53.333%) in additional financing. Since R is available from the retained profit, only R is required from external funding. 3. CASH BUDGETS Higgins (2007:105) describes a cash budget as a simple listing of projected cash receipts and payments over a forecast period for the purpose of anticipating future cash shortages or surpluses. Company accounts are based on accrual accounting while cash budgets use strictly cash accounting. This necessitates translating projections regarding sales and purchases into their cash equivalents. For example, if customers are granted 60-day terms, cash receipts from debtors in any month would represent the credit sales made two months earlier. Helfert (2003:185) states that when preparing a cash budget, a time schedule of estimated receipts and payments of cash are stated. This schedule shows, period by period, the net effect of projected activity on the cash balance. Items that do not represent cash flows e.g. depreciation are omitted. The time intervals selected may be daily, weekly, monthly, or even quarterly. THINK POINT 2! Drawing up a cash budget is time-consuming. So why do you think an enterprise may find it necessary to do day-by-day projections (day-by-day budget)? Figure 2-13 shows a typical format of a cash budget: MANCOSA BBA Year 3 28

31 Figure 2-13 Dino Limited Cash budget for the period 01 April to 30 June 20.9 April May June Cash receipts Cash sales Receipts from debtors Cash payments (20 920) (21 320) Cash purchases of merchandise Payments to creditors for merchandise Operating expenses Interest on loan Cash surplus (shortfall) Opening cash balance Closing cash balance Since the preparation of cash budgets is discussed extensively in topic 7, it will not be duplicated here. 4. SELF-ASSESSMENT ACTIVITIES 4.1 Brad Limited sells a single product at a selling price of R50 per unit. The estimated sales volume for the next 4 months of 20.9 is as follows: Units April May June July Management s policy is to maintain ending finished goods inventory each month at a level equal to 50% of the next month s budgeted sales. The finished goods inventory on 31 March 20.9 was units. To make one unit of finished product, 3 kilograms of materials are required. The cost per kilogram of raw material is R6. MANCOSA BBA Year 3 29

32 Other production costs per unit as at 31 march 20.9 are as follows: Direct labour R10 Overheads R7 As from 01 April 20.9 direct labour costs are expected to increase by 10%. Overheads are expected to increase by 2% per month. Required Prepare the sales budget for April, May and June Calculate the number of units that must be produced for April, May and June Calculate the total production cost for April, May and June Calculate the cost of sales for April, May and June 20.9 using the FIFO method Calculate the value of closing inventory on 30 June In November 20.8 GHI Manufacturers started making budget plans for the 12 months commencing 01 January Projected sales volume was R as compared to an estimated R for the financial year ended 31 December The best estimates of the operating results for the current year (20.8) are shown in the income statement below. Following this statement are the specific working assumptions with which to plan the financial results for the next year. Income Statement for 20.8 R Sales Cost of sales ( ) Labour Materials Overheads Depreciation Gross profit Selling expenses General and administrative expenses ( ) ( ) Profit before tax Income tax ( ) Net profit MANCOSA BBA Year 3 30

33 Assumptions for the financial year 20.9: Manufacturing labour will fall to 24% of sales because volume efficiency would more than offset higher wage rates. Materials cost would increase to 14.5% of sales because some price increases wouldn t be offset by better utilisation. Overhead costs would rise above the current level by 6% of the 20.8 Rand amount, reflecting higher costs. Additional variable costs would be incurred at the rate of 11% of the incremental sales volume. Depreciation will increase by R20 000, reflecting the addition of some production machinery. Selling expenses would rise more proportionately, by R , since additional effort would be required to increase sales volume. General administrative expenses would drop to 8.1% of sales. Income tax is estimated at 30% of pre-tax profits. Required Prepare a pro forma income statement for GHI Manufacturers for In December 20.8, Finch Limited was planning its financial needs for the coming year. As a first indication, the firm s management required a pro forma balance sheet as at 31 December 20.9 to gauge the financial needs at that time. Estimated financial condition as at 31 December 20.8 was reflected in this balance sheet: MANCOSA BBA Year 3 31

34 Estimated Balance Sheet at 31 December 20.8 R ASSETS Non-current assets Property, plant and equipment Accumulated depreciation ( ) Other non-current assets Current assets Inventories Accounts receivable Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity Ordinary share capital Retained income Non-current liabilities Mortgage bond Current liabilities Accounts payable Other current liabilities Total equity and liabilities Additional information Operations for the following year were projected using the following working assumptions to plan the financial results: Sales (all credit) were forecast at R , with a gross margin of 8.2%. Purchases (all credit) are expected to total R Accounts receivable would be based on a collection period of 12 days, while 24 days accounts payable would be outstanding. Depreciation is expected to be R for the year. A mortgage loan repayment of R is expected to be made. Other current liabilities will be allowed to fluctuate with seasonal needs. MANCOSA BBA Year 3 32

35 Capital expenditures were scheduled at R for a delivery van and R for warehouse improvements. Net profit after tax is expected at a level of 0.19% of sales. Dividends for the year were scheduled at R Cash balances are desired to be no less than R Required Prepare the pro forma balance sheet as at 31 December SOLUTIONS THINK POINT 1! The obvious implication is that the enterprise will generate more cash than necessary to run the business. Management will then have to decide how best to utilise the excess. THINK POINT 2! If daily fluctuations in cash are likely to be large, as in the banking business, then day-to-day projections are necessary Sales budget for April, May and June 20.9 Units Unit price (R) Budgeted Sales (R) April May June R50 R50 R Production requirements (units) April May June Sales forecast Desired closing inventory Total budgeted production needs Opening inventory (3 500) (5 000) (4 000) Required production MANCOSA BBA Year 3 33

36 4.1.3 Unit cost R Direct materials (3kg X R6) Direct labour (R10 + R1) Factory overheads 7.14 (R7 + R0.14) Total unit cost Total production cost April May June Required production (units) X Unit cost R36.14 R36.14 R36.14 Total production cost R R R Cost of sales for April R Opening inventory [(R18+R10+R7) X 3 500] Production ( ) [R36.14 X 3 500] Expected cost of sales Cost of sales for May R Opening inventory [R36.14 X 5 000] Production ( ) [R36.14 X 5 000] Expected cost of sales Cost of sales for June R Opening inventory [R36.14 X 4 000] Production ( ) [R36.14 X 4 000] Expected cost of sales MANCOSA BBA Year 3 34

37 4.1.5 Value of closing inventory April (R) May (R) June (R) Opening inventory Total production cost Total inventory available for sale Cost of sales ( ) ( ) ( ) Closing inventory April May June OR X R X R X R36.14 = R = R = R GHI Manufacturers Pro Forma Income statement for 20.9 Sales Cost of sales ( ) Labour Materials Overheads Depreciation R Gross profit Selling expenses General and administrative expenses ( ) ( ) Profit before tax [ X 24%] [ X 14.5%] [ * **] [ ] [ ] [ X 8.1%] Income tax ( ) [ X 30%] Net profit N.B. * ** Overheads: X 6% = ( ) = X 11% = MANCOSA BBA Year 3 35

38 4.3 Finch Limited Pro Forma Balance Sheet at 31 December 20.9 ASSETS Non-current assets Property, plant and equipment Accumulated depreciation Other non-current assets R ( ) Current assets Inventories [ ] [ ] [no change] [*see calculation below] Accounts receivable [ X ] Cash and cash equivalents Total assets [desired level] EQUITY AND LIABILITIES Equity Ordinary share capital Retained income [no change] [ ** ] Non-current liabilities Mortgage bond [ ] Current liabilities [ ] Accounts payable Other current liabilities [ X ] [ ] Total equity and liabilities * Inventories Opening inventory Purchases Goods available for sale Cost of sales ( ) [ X (100% 8.2%)] Closing inventory ** Retained income Net profit after tax = R X 0.19% = MANCOSA BBA Year 3 36

39 TOPIC 3 MANAGEMENT OF WORKING CAPITAL LEARNING OUTCOMES Students should be able to: describe the cycle of working capital of manufacturers and traders. implement appropriate strategies in the management of each of the elements of working capital explain the costs and risks of holding cash and of holding little or no cash. provide reasons for the granting of credit. discuss the costs and risks of granting credit and of denying credit. provide reasons for holding inventory. identify the costs and risks of holding inventory and of holding little or no inventory. elaborate on the costs and risks of taking credit and of not taking credit. explain the use of liquidity ratios. CONTENTS 1. Introduction 2. Cycle of working capital 3. Management of cash 4. Management of accounts receivable/trade debtors 5. Management of inventory 6. Management of accounts payable/trade creditors 7. Management of bank overdraft and short-term loans 8. Measures of liquidity 9. Self-assessment activities 10. Solutions MANCOSA BBA Year 3 37

40 READING Recommended reading Dempsey, A. and Pieters. (2005) H.N.Introduction to Financial Accounting 5 th Edition. Durban: LexisNexis. pp Keown, A., Martin, J.D., Petty, J.W. and David, F.J. (2002) Financial Management: Principles and Applications. 9 th Edition. New Delhi: Prentice-Hall. pp McLaney, E. (2003) Business Finance: Theory and Practice. 6 th Edition. Essex: Prentice Hall. pp Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1 st Edition. North Ryde: McDraw-Hill. pp Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5 th Edition. Durban: LexisNexis Butterworths. pp MANCOSA BBA Year 3 38

41 1. INTRODUCTION Working capital may be described as the difference between current assets and current liabilities. Meredith and Williams (2005:248) add that it represents funds needed for the day-to-day running of an enterprise i.e. funds that will work for the enterprise in generating profit, meeting short-term obligations and providing a pool of cash necessary for short-term liquidity. Current assets, a major component of working capital, are assets that are expected to be turned into cash within a year and include the following: Cash and bank balances Trade debtors Inventory Short-term investments Prepayments Current liabilities, the other component of working capital, are debts that are payable with 12 months. They include: Bank overdrafts Trade creditors Short-term loans Revenue received in advance 2. CYCLE OF WORKING CAPITAL Meredith and Williams (2005:249) illustrate (see Figure 3-1) and describe the cycle of working capital of a manufacturer. The cycle usually starts with cash available in some form or the other. The manufacturer may approach trade creditors for the purchase of raw materials and some of the cash will eventually be used to pay trade creditors. During manufacturing raw material will be converted into work in progress (partly manufactured goods). Wages and other factory overheads will also have to be paid for in cash. After the work in progress is converted into finished goods, these goods are sold (often on credit) and the asset becomes a trade debtor. When customers settle their debts, trade debtors are converted into cash and this cash may be used to pay for other commitments e.g. MANCOSA BBA Year 3 39

42 administration expenses, dividends and tax. Figure 3-1 Other commitments Cash Trade debtors Trade creditors Finished goods inventory Wages and overheads Raw material purchases Work in progress The necessity for the current asset component to exceed the current liability component is demonstrated in the cycle above. In other words, cash plus work in progress, finished goods inventory and trade debtors must exceed the commitments to pay trade creditors, wages and overheads. If the cash component is weak, the entire working capital cycle is weak, and thus every component in the cycle must be managed. We will be discussing the management of these components shortly. The cycle of working capital for retailers and wholesalers is relatively simple and is illustrated by Meredith and Williams (2005:251) in Figure 3-2. A feature of these two industry groups is that inventory and debtor levels are high, although these tend to be offset by high level of creditors and maybe an overdraft. The relationship between current assets and current liabilities may thus be virtually 1:1. MANCOSA BBA Year 3 40

43 Figure 3-2 Other commitments Cash Trade debtors Trade creditors/ Wages Inventory for resale The above cycle shows cash used to purchase inventory through creditors as well as paying wages and other commitments. Inventory is kept for resale and turned over as quickly as possible. Sales, when made on credit, lead to trade debtors and eventually to cash. The cycle is shortened if inventory is sold for cash only. We now examine the management of the components of working capital. 3. MANAGEMENT OF CASH Cash or its equivalents may include petty cash, cash in bank accounts and shortterm investments on call. Cash is crucial to the survival of any enterprise. Meredith and Williams (2005:252) provide the following reasons for the importance of the availability of cash: Lack of cash for a prolonged period leads to liquidation or bankruptcy. There are costs associated with the management of cash resources. A shortage of cash may increase costs in the form of financial and interest charges. Effective control of cash allows management to take advantage of investment opportunities that may arise at any time. Lenders insist that funds be available at any time to repay loans when necessary. 3.1 Motives for holding cash John Maynard Keynes cited in Keown et al. (2002:637) segmented an enterprise s motives for holding cash into three categories: MANCOSA BBA Year 3 41

44 3.1.1 Transaction motive Cash held for transaction purposes allows the enterprise to meet cash needs that arise in the ordinary course of business e.g. pay wages, purchase inventory etc Precautionary motive Cash is required to provide a safety cushion or buffer to meet unexpected cash needs e.g. a creditor demanding payment earlier than expected Speculative motive Cash is held in order to take advantage of potential profit-making situations that may arise at any time e.g. place a larger order for inventory than usual in order to exploit a temporary price advantage. THINK POINT 1! How can cash flow predictability affect an enterprise s demand for cash through the precautionary motive? 3.2 Cash management strategies Mclaney (2003:367) provides the following strategies in the management of cash and overdrafts: Establish a policy The enterprise should establish a policy for cash. This policy should be adhered to until it is formally reviewed Plan cash flows Failure to plan cash inflows and outflows and to balance them can be fatal. This can be done by drawing up a cash budget. The cash budget (discussed in topics 2 and 7) shows expected cash receipts, expected cash payments and the net change in cash for the period (day, week, month, quarter etc.) under review. The cash budget helps to identify cash shortages and gives the enterprise adequate time to arrange the necessary credit (e.g. bank overdraft) to meet the short-term cash needs. MANCOSA BBA Year 3 42

45 THINK POINT 2! What advice would you offer to an enterprise whose budget reflects temporary cash surpluses? Make judicious use of bank overdraft and deposit accounts Bank overdrafts should be avoided, if it is possible to do so. Temporary cash surpluses should be put into notice deposit accounts or invested in marketable securities Bank frequently Cheques received should be promptly banked to either generate income or save on interest on overdraft. Debtors should be encouraged to make direct or electronic payments in order to limit the time the bank takes to reflect such receipts. Other cash management strategies include the following: Extending accounts payable This involves stretching the payment period to creditors beyond the credit terms allowed but without affecting credit ratings negatively. However, if a creditor offers a discount for prompt settlement of account, the enterprise must compare the benefit of early payment with the cost of forgoing the cash discount. The calculation for the cost of forgoing a cash discount is explained in topic 5 (paragraph 4.1) Efficient purchasing and inventory management Another way of improving liquidity is to increase inventory turnover. This may be achieved in the following ways: Improving the accuracy of demand forecasts and better planning of purchases to coincide with these forecasts. Through better purchasing planning, an enterprise can reduce the length of the purchasing cycle. This should increase inventory turnover. MANCOSA BBA Year 3 43